March 11, 2010
Good morning. I would like to thank the Futures Industry Association for inviting me to speak here this morning. I also want to thank the international regulators who flew in from around the globe to join our meeting yesterday to discuss and coordinate our financial reform efforts. I would like to use this opportunity to discuss much-needed regulatory reform of the over-the-counter derivatives marketplace as well as to update you on some of the changes we hope to make at the CFTC. I am going to discuss these issues in the context of two significant events in American history, both of which occurred in mid-19th Century Chicago.
Mrs. O’Leary’s Cow
As most of us learned as school children, in 1871, what started as a small fire quickly spread through Chicago to destroy much of the city. The story goes that it was ignited when Mrs. Catherine O’Leary’s cow kicked over a lantern in her barn. Many of the buildings in Chicago were made of wood, so the fire spread too quickly for firefighters to extinguish it. As a result of the fire, Chicago implemented new building and fire codes to prevent a repeat of the disaster. While Chicago didn’t burn down solely because of weak building codes, those new rules went on to protect the residents of Chicago from the spread of future fires.
The First Derivatives Markets
Another important event in Chicago, just six years before Mrs. O’Leary’s cow kicked over that infamous lantern, was the starting of derivatives trading. Of course everybody in this room knows these derivatives as futures, which started trading when farmers and grain merchants came together to hedge their price risk in corn, wheat and other grains. It took nearly 60 years before Congress brought regulation to this earlier derivatives marketplace to lower risk and promote transparency and market integrity. The Commodity Exchange Act, which passed after the last great financial crisis, established regulations in the futures markets to protect the American public.
Fast forward decades later to the 1980s and further innovations in the marketplace led to trading of derivatives that were off-exchange and thus out of sight of market participants, regulators and the public. These new over-the-counter derivatives were developed so that corporations and other entities could hedge their tailored risk in ways that the standardized futures marketplace at the time might not facilitate. Derivatives dealers were not subject to regulation when selling their products bilaterally. Nearly thirty years later, this market has exploded to $300 trillion notional amount in the U.S. – by some measures nearly ten times the size of the regulated futures markets – and yet remains unregulated.
In the fall of 2008, certain financial institutions dealing in unregulated derivatives kicked over the lantern that ignited the financial crisis – a fire that nearly burned down the global economy. Over-the-counter derivatives were at the center of the failure of AIG. They were used to add leverage to the financial system by taking on more risk backed up by less capital. The recent chill winds blowing through Europe, including press reports that Greece used derivatives to help mask its fiscal health, are reminders of the pressing need for comprehensive regulation. The financial crisis demonstrated how over-the-counter derivatives – initially developed to help manage and lower risk – can actually concentrate and heighten risk in the economy and to the public. The time has now come to establish building codes in the over-the-counter derivatives marketplace.
Now I’m quite familiar with the reasons that have been given over the years why over-the-counter derivatives should not be subject to similar building codes as futures. No doubt, there are a number of you at this conference who have opposed regulation. It was said that over-the-counter derivatives are highly tailored and too customized to trade on exchanges or other trading platforms or be centrally cleared. In the past 30 years, however, these products have become far more standardized, and computerization facilitates more efficient trading. In fact, a CEO of one major Wall Street bank said he believes that 75-80 percent of the market is standard enough to be centrally cleared.
Another assumption has been that at least one party to a transaction – the derivative dealer – is already regulated. The financial crisis highlighted that this is flawed assumption. In some cases, even when a dealer may have been part of a larger regulated financial institution, its derivatives business was not explicitly regulated. In other cases, such as with AIG and the investment banks, their derivatives affiliates had no effective regulation at all.
And yet another rationale was that the over-the-counter marketplace did not need oversight because it is an institutional marketplace with sophisticated participants. But in 2008, the U.S. taxpayers had to bail out these “sophisticated” market participants with their hard-earned dollars.
Regulation of Over-the-Counter Derivatives
While it took 60 years, a World War and a major financial crisis to establish building codes in the futures marketplace, I am hopeful that with swaps we can be more efficient and get the job done in less than 30 years after the first swap transaction. A comprehensive regulatory framework governing over-the-counter derivatives should apply to all dealers and all derivatives, including interest rate swaps, currency swaps, foreign exchange swaps, commodity swaps, equity swaps, credit default swaps and any new product that might be developed in the future. Effective reform of the marketplace requires three critical components:
First, we must explicitly regulate derivatives dealers. They should be required to have sufficient capital and to post collateral on transactions to protect the public from bearing the costs if dealers fail. Dealers should be required to meet robust standards to protect market integrity and lower risk and should be subject to stringent record-keeping requirements.
Second, to promote public transparency, standard over-the-counter derivatives should be traded on exchanges or other trading platforms. The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk. Transparency brings better pricing and lowers risk for all parties to a derivatives transaction. During the financial crisis, Wall Street and the Federal Government had no price reference for particular assets – assets that we began to call “toxic.” Financial reform will be incomplete if we do not achieve public market transparency.
There are two models as to how capital and risk get allocated in an economy. One is through transparent exchanges and other trading venues; the other is through financial intermediaries, such as banks and dealers. The public has benefited for decades from transparency and efficiency of the securities and futures markets. Such transparent trading brings both real time post-trade transparency and some pre-trade transparency. Bringing transparency to the regulators is not enough; we must bring real-time transparency to the public through exchanges and other trading venues. Wall Street, on the other hand, has benefited from opacity and inefficiencies in the over-the-counter derivatives market, a market dominated by a handful of dealers in this country. But in this particular market and at this time in our history, we need markets that work for the American public.
Third, to lower risk further, standard over-the-counter derivatives should be brought to clearinghouses. Clearinghouses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. Clearinghouses in the futures markets have been around since the late-19th Century and have functioned both in clear skies and during stormy times – through the Great Depression, numerous bank failures, two world wars and the 2008 financial crisis – to lower risk to the American public. While no TARP money was used to cover market exposures on cleared futures transactions, AIG had to be bailed out in part to cover uncollateralized and uncleared derivatives contracts.
To ensure fairness and competition in the over-the-counter derivatives marketplace, swaps clearinghouses should have open access, where they would be required to take on trades from any regulated exchange or swap execution facility. Clearinghouses should not be allowed to discriminate between or amongst the trades coming from one trading venue or another. Clearinghouse governance should be open to both dealers and non-dealers. Open governance would ensure that clearinghouses are not governed by parties that might have a conflict of interest or financial stake in particular transactions. Lastly, clearinghouses should have open membership. Assuming a party meets the rigorous risk-management, operational and financial requirements of a clearinghouse, it should be permitted to become a direct member of that clearinghouse. Membership criteria should be transparent, objective and nondiscriminatory.
Let there be no mistake: Wall Street has not been enthusiastic about this reform. They would prefer transparency only be brought to the regulators or at most that regulators just publish aggregate trading data rather than real-time trade information. Just imagine if that’s all we did in the stock market how poor America would be. Instead, we should bring building codes to the over-the-counter markets by moving the standard part of the market to trading venues. We could thus achieve both real time post-trade transparency and the benefits of some pre-trade transparency, just as we have in the futures and securities markets. Just think how much richer America would be.
Some on Wall Street and some in this room will agree that we must bring regulation to the over-the-counter marketplace. In fact, there is broad consensus among Congress, the Administration and many in the industry that derivatives dealers should be comprehensively regulated. Many in the industry have also indicated support for a clearing requirement – that is, as long as it only applies sometimes. Wall Street appears to be aligning themselves with corporate end-users in an effort to exempt customer transactions from central clearing. While only approximately 9 percent of the market represents transactions between dealers and non-financial end-users, Wall Street seems to be making the case that financial end-users also should be exempt. This could possibly leave 60 percent of the clearable market outside of clearing. Wall Street might express partial support for a clearing requirement, but when it comes to the trading requirement, they appear rather allergic. After all, Wall Street has a fiduciary duty to its shareholders and will look to maintain its information advantage. After the worst crisis in 80 years, though, we need real reform that protects the American public.
Enforcing the CFTC’s Building Codes
In addition to establishing building codes in the over-the-counter derivatives markets, we need to strengthen the CFTC’s ability to do its job overseeing the futures markets. In the first eight years of the century, the CFTC’s staff shrunk by more than 20 percent as our funding lagged behind the more than 400 percent growth of the markets. While market participants have the technology to automate their trading, we’ve yet to have the resources to employ modern technology to automate our surveillance and oversight of compliance. Further, the CFTC has yet to have staffing levels to conduct regular annual examinations of exchanges and clearinghouses.
In his FY 2011 budget proposal, the President requested a $47 million or 33 percent increase in our resources to fulfill our mission and better protect the American public. With this increase, the CFTC will be able to move toward state-of-the-art automated surveillance and compliance and conduct more regular examinations of our registrants. This will improve the efficiency of the agency and of the markets. If over-the-count derivatives reform is enacted, even further resources will be needed.
I thank you for inviting me to speak with you today. Even when we disagree, I appreciate the frank exchange of ideas. Many of you have come in to meet with the Commission and our staff or have provided comments on our proposed rules and determinations, and I thank you for being part of the process. On both topics of regulatory reform and our current oversight of futures markets, I would like to continue our open dialogue.
Thank you, and I will now take you questions.
Last Updated: January 24, 2011